This paper analyzes the origins, implications, and solutions for the Asian financial crisis. From the perspective of a member of the Executive Board of the IMF, as Asian problems were building, the IMF overlooked weaknesses in bank and corporate balance sheets in much of Asia: the IMF was unaware of the extraordinary leverage of Korean companies, which in some cases reached a ratio of 600/1 debt to equity. The IMF did not focus on the weak accounting and disclosure practices of banks and nonbanks or generous rollovers of banks to their key clients.

This chapter summarizes the discussion and findings in Kaminsky and Reinhart (1998a, 1998b, and 1998c), Kaminsky, Lizondo, and Reinhart (1998), and Kaminsky (1998) who examine eighty currency crises from twenty countries during 1970–1997.

The spectacular collapse of several Asian currencies in 1997 and the globalization of the so-called Asian flu into a major epidemic engulfing countries in Europe, Africa, and most of all in Latin America have rekindled the eternal question of whether these crises could have been avoided. Naturally, for governments to adopt preemptive measures, it is necessary to detect the symptoms of crises early on. This brings up the question of the possibility of constructing an early warning system to help monitor countries that are likely to be the subjects of speculative attacks against their currencies.

Naturally, if financial panics had been at the core of the Asian crises and the worldwide waves of turbulence in 1997–1998, it would have been impossible to predict let alone avoid them. This is because, according to this view, the trigger of financial crises is a sudden shift in market expectations and confidence, unrelated to macroeconomic fundamentals. The only hope at controlling or at least lessening the severity of these speculative attacks would be to introduce “sand in the wheels” of international capital markets.

In contrast, if these crises were the result of an unsustainable deterioration in macroeconomic fundamentals, it can be argued that it is possible to construct a warning system that will pinpoint poor domestic policies or unusually adverse external shocks. Yet, alerting about upcoming currency crises would prove to be an impossible task if, as some have claimed, the nature of crises is changing. If the Latin American debt crisis is the result of irresponsible fiscal finances, the 1992–1993 ERM crises are of a self-fulfilling nature and triggered by rumors unrelated to market fundamentals, and the Asian crises are the product of moral hazard behavior by banks, the hopes of constructing an early warning system are dashed to pieces because trying to forecast an upcoming crisis would be like shooting at a moving target. An essential ingredient to make this task possible is that crises should be of a similar nature or at least follow a certain pattern.

This chapter builds on the view that many of the features and antecedents of the Asian crises are common to a substantial number of crisis episodes in the past, such as the Debt crisis in the early 1980s or the ERM crises in 1992–1993. Moreover, it shows that, in fact, the Asian crises are preceded by the same signs of distress observed in the Latin American economies at the onset of the Debt crisis. This evidence that common factors preceded crises as far apart in distance and time as the Debt crisis and the Asian crises suggests that it is in fact possible to construct an early warning system to help monitor whether a country may be slipping into a potential crisis.

1. ON THE CAUSES OF CURRENCY CRISES: LITERATURE REVIEW

The currency crises of the 1970s, 1980s, and the 1990s have generated a prolific and still-growing literature on balance-of-payments problems. This section briefly reviews this literature to pinpoint the triggers of past episodes of crises and to examine the possible sources of vulnerability of the Asian economies at the beginning of the 1997–1998 crises.

Many of the theories of currency crashes emphasize that extended credit is at the core of these crises. Still, the source of extended credit varies across models. For example, Krugman (1979), inspired in the Latin American currency crises of the 1970s, focuses on the monetization of the government deficit. In a similar vein, but this time focusing on the currency crisis in Chile in 1982, Diaz-Alejandro (1985) highlights that difficulties in the banking sector can give rise to a balance-of-payments crisis and argues that if central banks finance the bailout of troubled financial institutions by printing money, we have the classical story of a currency crash prompted by excessive money creation. More recently, McKinnon and Pill (1994) and Kaminsky and Reinhart (1998a) stress the role of financial liberalization and foreign capital inflows channeled through domestic banks, deposit insurance, moral hazard, and overlending. In this approach, currency crises occur as an economy enters a recession that follows a prolonged boom in economic activity fueled by credit creation and surges in capital inflows. The cycle of overlending is exacerbated by implicit or explicit deposit insurance, poor supervision, and moral hazard problems in the banking sector. Crises are accompanied by an overvaluation of the currency, weakening exports, the bursting of asset price bubbles, and overall banking fragilities.

Stimulated by the EMS collapses in 1992 and 1993, other models of currency crises have stressed government officials’ concern on, for example, unemployment. Governments are modeled facing two targets: reducing inflation and keeping economic activity close to full employment. Fixed exchange rates may help in achieving the first goal but at the cost of a loss of competitiveness and a recession. With sticky prices, a devaluation may restore competitiveness and help in the elimination of unemployment, thus prompting the authorities to abandon the peg during recessions.

Whether crises have a fiscal origin a la Krugman or a banking problem à la Diaz-Alejandro or countercyclical government policy as in Obstfeld (1996), speculative attacks can become more severe when foreign debt has reached “dangerous” levels and there is a bunching of maturing loans, that is, when foreign debt is concentrated at very short maturities. In this case, monetary policy tightenings in industrial countries can fuel sudden reversals of capital flows leaving emerging markets scrambling for liquidity. Problems mount even further in the presence of capital flight with gross inflows of capital only financing domestic residents investments overseas. This phenomenon of coexistence of inverse and offsetting capital flows, with domestic residents often choosing to invest their savings in international capital markets at the same time that they are seeking external finance has been an important feature during the debt crisis.

2. QUANTIFYING THE SIGNS OF DISTRESS

To examine whether the Asian crises are of a new breed, I examine the behavior of twenty-one macro and financial indicators at the onset of the Asian balance-of-payment problems in 1997 and compare to their behavior in Latin America at the start of the Debt crisis in 1982.1

The indicators used to capture the overborrowing cycles include the M2 multiplier, the ratio of domestic credit credit to nominal GDP, and an indicator of domestic and external financial liberalization.2 Increases in any of these indicators might signal possible financial sector problems. Problems can compound in the presence of bank runs, which are captured by the growth rate of bank deposits (in real terms). Loose monetary policy is captured by “excess” real Ml balances. Current account problems are captured using the following indicators: exports, imports, the terms of trade, and the real exchange rate, with increases in imports and real appreciations of the domestic currency and the deterioration of exports and the terms-of-trade signaling potential problems in the current account. The capital-account indicators are foreign exchange reserves of the central bank, M2/reserves, domestic foreign real interest rate differentials, world interest rates, foreign debt (as a percentage of foreign exchange reserves), capital flight (which is captured using deposits of domestic residents in BIS banks), and short-term foreign debt (as a percentage of total foreign debt). Reserve losses and increasing interest rate differentials are signals of future problems in the capital account. The ratio of M2 (in dollars) to foreign exchange reserves in dollars is used to examine to what extent the liabilities of the banking system are backed by international reserves. High foreign debt concentrated at short maturities and capital flight can complicate the external outlook for the domestic economy. Finally, high world real interest rates can anticipate capital outflows from emerging economies and currency attacks. I include output, stock prices (in dollars), domestic real interest rates, and the ratio of lending-to-deposit interest rates to capture growth slowdown, with declines in output, stock-market crashes, high real interest rates and lending-to-deposit interest rates ratio signaling impending crises. Finally, a banking crisis indicator is also used to characterize the start of currency crises.

Naturally, not every real appreciation of the domestic currency anticipates a crisis, nor does every single boom in credit markets. In previous work (with Carmen Reinhart), we conclude that an indicator can provide an early warning of future crises only when its behavior departs significantly from its behavior in tranquil times. That is, for an indicator to give a signal of an impending crisis this indicator has to exhibit “anomalous” behavior on the eve of a crisis.3

An assessment of the degree of fragility and the sources of distress of the four Asian countries at the onset of the 1997 crises is provided. I quantify, crisis by crisis, the number of the twenty-one indicators showing “unusual” behavior in the twenty-four-month period prior these crises.4

With the exception of Indonesia, all the Asian countries show a severe state of distress with about sixty-five percent of the indicators flashing red lights. These currency crises are the paradigm of a typical financial crisis with the onset of these crises occurring as the economies enter a marked slowdown in growth after a prolonged boom in economic activity fueled by rapid credit creation. This dramatic surge in credit is, in large part, explained by heavy capital inflows and partly by the reform of the financial system, which is accompanied by drastic reductions in reserve requirements. Overall, the explosive growth in these countries comes to an end with a real appreciation of the domestic currency and the corresponding loss of export markets and in the midst of financial fragilities.

For example, short-term capital inflows to Thailand amount to seven-tenths percent of GDP in each of the years 1994–1996, with the growth rate of credit to the nonfinancial private sector over 1990–1995 being more than twenty-three percent. While in the early 1990s, output growth rates increase to almost nine percent fueled in part by easy credit, the explosive growth in Thailand comes to an end with the real appreciation of the domestic currency and the corresponding loss of exports markets (the annual growth rate of exports falls from a peak of thirty percent per year in 1994 to about zero in 1996). Financial fragilities are also evident, with runs against major banks starting to occur in as early as May 1996. Finally, the sharp increase in interest rates in 1997 to defend the baht puts the nail in the coffin of the already defunct banking sector. Overall, seventy-five percent of the indicators for which there is available data were exhibiting “anomalous” behavior.

The boom–bust cycle in lending is also evident in the Philippines, fueled as in Thailand by capital inflows but also by a dramatic reduction in reserve requirements. Bank credit increases by forty-four percent a year in 1995–96. As in Thailand, the rapidly expanding credit is an important contributor to the rally in stock and real estate markets, with a four-fold increase in prices in both markets. As in other countries in the region, foreign currency exposure increases in the Philippines in the 1990s through foreign borrowing to finance domestic lending, with foreign borrowing concentrated at short maturities. Consumer lending also increases and fuels a surge in consumption, leading to a deterioration of the current account, which is accentuated by the real exchange rate appreciation of the domestic currency. The loss of competitiveness anticipates a future decline in growth and also contributes to a substantial deterioration of the quality of banks’ assets, further reducing the odds of survival of many individual financial institutions. Overall, in the Philippines, about fifty percent of the indicators are signaling the increased vulnerability of the economy in the two years prior to the collapse of the peg in July 1997.

Malaysia has a number of features in common with Thailand. It is also affected by the slowdown in the region, though to a much smaller degree. It also has current account deficits similar in magnitude to those in Thailand in the period 1990–1995, although in 1996 the outlook of the external sector improves somewhat with the current account/GDP ratio declining to –5.3 percent (In Thailand the current account/GDP ratio in 1996 is still –8.0 percent). Moreover, Malaysia as Thailand accumulates debt rapidly in the 1990s, with capital inflows fueling a stock and real estate market boom, with prices increasing about 300 percent in the early 1990s. Malaysia is also suffering from financial fragilities as a result of the high degree of leverage of the economy (Malaysia has one of the highest credit-to-GDP ratio in the world) and the large exposures to the property and stock markets. For Malaysia, about sixty percent of the indicators are showing signs of distress at the onset of the crisis.

Indonesia, however, looks somewhat different. While it is still true that, as the other countries in the area, it is exhibiting banking fragilities5 and short-term debt sharply exceeds available foreign exchange reserves (about 1.7 times the stock of foreign exchange reserves of the country), the current account deficit is not deteriorating as fast—only reaching 3.5 percent of GDP in 1996, the slowdown in growth is not yet evident, and the real exchange rate does not appreciate as much as in the other countries in the region. Only very few indicators (less than twenty percent) are showing signs of strains in the economy in the months prior to the crisis. While the degree of distress in the domestic economy in the months prior to the crisis cannot explain the meltdown of the rupiah and of the economy as a whole in 1998, the flurries of financial crises in 1997 do add a severe element of instability as Indonesia and the other countries in the region are left scrambling for liquidy when Japanese banks—the major lenders to the region—pull out rapidly across the regions after the major losses suffered in the wake of the Thai crisis.6

For comparison, the same catalogue of macro fragilities for four Latin American economies during the debt crisis in the early 1980s again show signs of distress are widespread. For example, in Argentina, the failure of major banks in March 1980 results in a sharp increase in central bank lending to the financial system, with the growth rate of credit to the private sector increasing two-fold from the end of 1980 to the end of 1982. As in Asia, the collapse of the banking sector is preceded by a lending boom, fueled by capital flows in the late 1970s, which in turn trigger a consumption boom, a current account deficit, and a sharp appreciation of the domestic currency.7 The next domino in this crisis is Chile. Again financial fragilities are at the heart of the currency crisis with the usual pre-crisis symptoms of a credit boom, leading to consumption booms and current account deficits.8 The resolution costs of the banking crises in these two countries amounted to about forty percent of GDP. The Mexican and the Uruguayan crises in 1982 shared similar problems. Overall, more than ninety percent of the indicators were showing signs of abnormal behavior.9 Thus, while far apart in time and distance, the crises in Latin America and Asia suggest a common pattern and the possibility of constructing a warning system pointing déjà vu sources of fragility.

As shown in Kaminsky (1998), the signals issued by each indicator can be combined into a unique measure of the likelihood of balance-of-payment problems. Interestingly, the probabilities of currency crises for Thailand and the Philippines increase from a low of twenty percent in 1995 to about 100 and seventy percent, respectively, in 1997. For Malaysia, the probabilities of currency crises also increase almost reaching about seventy percent by the time the crisis erupts. Only the crisis in Indonesia remains unexplained by the composite indicator, which ignores the role of international bank lending.

3. CONCLUSIONS

I have examined the main culprits behind the 1997 Asian crises and compared the onset of these crises to that of other currency crises, such as the Debt crisis episode. The analysis suggests that many of the features and antecedents of the crises in Asia are common to previous crisis episodes in Latin American, and as shown in Kaminsky and Reinhart (1998a,b,c) are also common to the crisis episodes in Europe and elsewhere. We can only conclude that the Asian crises are of a new breed if we ignore the multiple lessons that history offers. The results presented also indicate that overall, crises are preceded by a common pattern of multiplying fragilities in all sectors of the economy, which can be used to anticipate when a country is likely to be subject to serious speculative attacks.

This chapter has focused on a specific early warning system for currency crises, which basically highlights poor domestic economic policy, either public or private, as the trigger of crises. I have examined, however, that the frailty of an economy can be exacerbated by currency crises in other countries. For example, Indonesia falls prey of a liquidity crunch when Japanese banks recall their loans from all Asian countries after suffering major losses with the devaluation of the Thai baht. Future work on early warning systems should combine the information on the domestic economy with that of possible spillover effects from other countries in crisis. Finally, work in this area should also assess the state of political instability and perhaps include information on the nature of the political institutions, which has been shown to help in understanding, for example, the sources of economic growth.

This is a dummy variable equal to zero when the domestic financial sector is regulated and there are restrictions to capital account movements and is equal to one when controls both in the domestic and external front have been lifted.

The reversal was in fact quite pronounced, from capital inflows to the region of $50 billion in 1996 to an outflow of $21 billion in 1997. See, Kaminsky and Reinhart (1998c) for detailed discussion on world and regional financial links and their effects on the odds of currency crises.

For example, real domestic credit increases at about 50 percent in 1979 while real private consumption increases about 15 percent in 1979 and about 8 percent in 1980, and the real exchange rate appreciates about 50 percent in the two years preceding the debt crisis.

For example, for Uruguay, real domestic credit increases on average 50 percent in the two years preceding the crisis and the real exchange rate appreciates about 40 percent since the stabilization program was implemented.